Traditional systems for enforcing risk limits on the trading of bonds and exchange listed derivatives employ set limits on the number of contracts or total financial position that a particular entity or trader can take. These limits typically take the form of so-called “clip size” limits, which prevent single trades above a pre-determined size (e.g., a single trade of 500 contracts). Additional “position” limits are used to prevent an entity from amassing a position above a certain size from a combination of multiple orders. Many systems use both clip size and position size limits as an initial filter to confirm that a potential order does not violate the limits.
These limitations are fairly straightforward to implement on routine financial instruments. In some instances, however, a particular trade may not violate the limits, but when grouped with a collection of other potential trades or existing positions, the limits are triggered. Moreover, because a particular trade may include multiple characteristics (class of instrument being traded, the period the instrument covers, the expiration of the instrument, the source of the trade request, etc.) one trade may implicate numerous potential risk limits.
As an example, some markets trade in derivative contracts that are constructed from a “strip” of contracts. Strip contracts allow for the sale or purchase of futures in sequential delivery months in a single security, thus allowing investors to secure conditions such as yields for a period of time equal to the length of the strip. In the electricity markets, a typical example might be a monthly delivery instrument for power, which is essentially a “strip” of daily delivery contracts, which may also be traded individually. The concept of a strip of contracts can be extended to quarterly contracts (each day in a quarter) annual contracts (each day in a year), etc.
Strip contracts may also cover overlapping delivery periods. For power delivery contracts, the overlapping periods might be “peak,” “off-peak,” and “baseload power.” Peak contracts deliver power in the middle of the day for the working week, off-peak deliver power during night and evening periods and weekends, and baseload contracts cover the entire period. Therefore, an off-peak strip plus a peak strip is equivalent to a baseload strip, assuming they are each covering the same period. Thus, buying baseload and selling off-peak and peak for the same period is effectively a wash.
Because of the temporal component to these contracts, traditional risk management systems that are based on setting individual limits for each contract or for groups of contracts are inappropriate for the trading of contracts which purchased in overlapping strips. To compensate, companies managing risk using existing risk systems are limited to setting total limits across an entire class of instruments, as they do not know specifically what contracts are being traded. Thus, because the limits are set for weekly, monthly, quarterly and annual contracts across all instruments regardless of overlap, the company's exposure would in fact be much higher than otherwise permitted. This may then require the company to deposit more risk capital than was initially planned for, or, alternatively the risk management firm may offer lower limits than they would prefer given the cash on deposit.
What is needed, therefore, is a methodology and supporting systems that consider the various possible groupings and overlapping nature of financial instruments when assessing the risk of proposed orders submitted into an exchange or other trade execution venue.